One of the more confusing aspects of ownership in either a partnership or limited liability company (LLC) is understanding the effect that partnership or LLC debt has on an individual partner’s or member’s tax basis in that entity. Knowing how debt affects one’s basis in an entity is important in determining how much a partner or member can deduct in losses that are otherwise passed through to him or her from that entity.
More importantly, it may be the deciding factor in determining the correct structure for the creation of an operating company.
The Basic Basis Rules 01
Perhaps this is a good time to review the general rules of determining a partner’s or member’s tax basis in his or her interest. A member/partner’s tax basis, in the context of the ability to deduct losses starts with the following:
Basis in the member’s (partner’s) interest is increased by –
- The amount of cash or the value of other assets he or she contributes to the entity,
- Any profits or gains allocated to that member/partner, and
- Any increase in the member/partner’s share of entity debt.
Basis in the member’s (partner’s) interest is decreased by –
- The amount of cash or value of other assets withdrawn from the entity by the member/partner,
- Any losses allocated to that member/partner, and
- Any decrease in the member/partner’s share of entity debt.
A further limitation on the ability to deduct losses can be found within the at-risk rules: where a member or partner can only deduct losses to the extent he or she is considered to be economically at-risk. So, in order to be able to deduct a $100 loss, one otherwise allocated to him in accordance with the entity’s operating agreement, a member or partner has to actually be in a position to lose $100 in real money. This is generally referred to as the amount the partner or member is “at-risk”. And as such the partner/member must determine his or her at-risk basis as well.
Why is this important? Well, if you look back to the items (above) that increase or decrease basis, you will note that an increase or decrease in a member or partner’s share of LLC or partnership debt can either increase or decrease that member or partner’s basis in the LLC or partnership. However, it is important to understand that there are two different types of debt that will have very different effects on a member/partner’s regular tax basis or “at-risk basis”; recourse and nonrecourse debt.
Recourse debt is debt that is backed by collateral from the borrower, in this case the partnership or LLC. It is debt generally where the partners are personally liable. While nonrecourse debt is the opposite. It is debt where no partner or member has personal liability for its repayment. So, a partner’s at-risk basis will include cash or property they have contributed to the partnership, plus their share of partnership debt for which they (1) are personally liable for repayment, (2) or where they have pledged property held outside of the partnership as security, or have directly loaned to the partnership. So recourse debt does not qualify or increase basis.
There is one additional type of debt that can increase a partner’s at-risk basis, and that is qualified nonrecourse debt. Qualified nonrecourse debt is financing that is (1) borrowed from a qualified lender (2) for the purpose of holding real property (3) for which no person is personally liable for repayment and (4) which is not convertible debt. So, here we have a case of debt that no one is responsible for repaying that still increases all the partners’ at-risk basis amounts.
Now, with a fundamental understanding of at-risk basis and recourse vs. nonrecourse debt, let’s look at the differences between partnership and LLC treatment. In the partnership world, there are two types of partners; general partners and limited partners. General partners generally receive no protection from personal liability for the debts of the partnership and are fully liable for those debts, while limited partners generally are protected from personal liability for any partnership debts, except for any debts they have personally guaranteed.
While virtually every partnership has at least one general partner who is fully liable for partnership debts, that is not the case with LLCs. In most instances, LLC members are treated as limited partners, having no personal liability for the LLC debts. How does that affect an LLC member’s at-risk amount or basis?
The IRS’s Clarification in AM 2014-003
The IRS released an Associate Chief Counsel Memorandum (AM 2014-003) that provides guidance to the issue of the at-risk rules, partnerships and LLCs. It does this by answering four specific questions. Additionally, the memorandum’s guidance applies both to LLCs classified as partnerships and single member LLCs (SMLLCs) treated as disregarded entities for federal tax purposes.
The first of the four questions outlined in the memorandum starts out fairly simply as it relates to the topic of debt and the at-risk rules with each subsequent question adding an additional layer of complexity. It is through this process that the guidance is developed as follows:
Question 1 asks what tax consequences surface under the at-risk rules of Code Sec. 465 to an LLC member who guarantees debt of that LLC. The response to this question explains in fairly significant but simple detail that, assuming the guarantee is legitimate, the LLC member will be able to increase his or her at-risk basis by the amount of the debt that has been personally guaranteed.
Question 2 then asks what tax consequences apply to an LLC member who guarantees debt of that LLC when the guaranteed debt is “qualified nonrecourse financing”. As I outlined earlier, qualified nonrecourse debt is debt financing that is (1) borrowed from a qualified lender (2) for the purpose of holding real property (3) for which no person is personally liable for repayment and (4) which is not convertible debt. Again, we have a case of debt that no one is responsible for repaying that still increases all the partners’ at-risk basis amounts.
The response to question 2 explains that once a member has guaranteed qualified nonrecourse debt, his (and only his) at-risk basis will increase, as in question 1. But the commentary goes on to explain that, since a member is now guaranteeing the repayment of this debt, the debt no longer meets the definition of qualified nonrecourse financing, which in turn affects the other non-guaranteeing members. The significance of this treatment is addressed in the next question.
Question 3 builds upon question 2 by outlining the tax consequences to the other non-guaranteeing members where one member has guaranteed qualified nonrecourse financing. As explained in the response to question 2, since the debt no longer meets the definition of qualified nonrecourse debt financing, the non-guarantor members may no longer include their share of that debt in the computation of their respective at-risk amounts. It also adds that if a reduction in their at-risk amounts occurs, causing their respective cumulative at-risk amounts (basis) to fall below zero, then the partners or members must recognize income to that extent.
Question 4 deviates from the above scenarios by repeating question 2, above, but limiting it to the member of an SMLLC. In this case, there are no other LLC members who are affected, and the SMLLC member sees no change in his at-risk basis. Why? As qualified nonrecourse debt, the member already had at-risk basis for that debt. By guaranteeing that debt, he still has at-risk basis, so the amount of his at-risk basis didn’t change. Unfortunately, in this case, his personal liability with regard to that debt went from zero to the amount he guaranteed.
With this memorandum, the IRS has provided some relatively uncomplicated guidance to a very complex issue (even though it probably didn’t sound particularly uncomplicated).